Foreign Investors Lose Hunger For U.S. Debt

April 30, 2018

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Foreign investors’ appetite
this year for U.S. debt hasn’t grown at the same pace as the government’s
borrowing needs, which some analysts worry could push bond yields higher and
eventually threaten to slow economic growth.

Investors in a broad
category known as “indirect bidders,” which includes both mutual funds and
foreign investors, have been winning the smallest percentage of the bonds
they’ve bid for since 2011, according to bidding data for recent Treasury bond
auctions. The average percentage of the auctions won by this group fell for the
first time since 2012, a decline some analysts attribute to both lower demand
from investors outside the U.S. and their recent tendency to post
less-aggressive bids.

The behavior of these
bidders is crucial for the ability of the U.S. to fund itself, at a time when
the budget deficit is forecast to surpass $1 trillion by 2020 and remain above
that level for the foreseeable future. Foreign investors currently hold about
43% of U.S. government debt, the lowest since November 2016, a proportion that
has steadily declined from its peak of 55% during the 2008 financial crisis.

The decline in foreign
demand comes as the yield on the 10-year U.S. Treasury note—a benchmark used to
help set the interest rates for mortgages, credit cards and business loans—hit
3% last week for the first time since 2014. Many investors and analysts expect
yields to climb further as the increase in U.S. borrowing due to tax cuts and
higher spending expands the supply of debt outstanding. Higher borrowing costs
could eventually become a drag on economic growth, increasing the potential for
a slowdown in the
long expansion.

While the percentage of
Treasurys held by foreign investors has declined, such buyers remain crucial to
the bond market, holding roughly $6.3 trillion of government debt. Even simply
rolling over maturing bonds at the auctions requires foreign investors’
participation. They have bought at least 17% of government auctions each year
since 2014, maintaining their support for the primary market during a period
where the share purchased by bond dealers has consistently declined.

“We cannot exist at these
growth rates with these deficit projections without foreign participation,”
said Andrea Dicenso, a portfolio manager and strategist at Loomis, Sayles &
Co.

Demand for Treasurys from
foreign investors has experienced a number of ebbs and flows over time, but the
securities are enmeshed in globe-spanning financial relationships that serve to
mute the impact of any one group, from central banks to broker-dealers. While
some investors have expressed concerns that China could sell a significant
block of its holdings, flooding the market with Treasurys at a period where the
U.S. is increasing new-issue sales, economists and other investors argue such a
move would run counter to China’s own economic interests.

Foreign holdings of
Treasurys rose last year for the first time since 2014, keeping pace with the
increase in government debt outstanding. In February, they climbed to $6.29
trillion of the $14.7 trillion of then-outstanding U.S. government debt, the
Treasury said April 16, up from $6.26 trillion the prior month.

The gains last year
notwithstanding, a persistent shift in bidding would represent a crack in the
mechanisms through which the Treasury has funded its operations through periods
of both prosperity and crisis.

While auction data on
“indirect bidders” doesn’t break out which components of the broader category
bid at what levels, extrapolating from trading during Asian and European market
hours points to weaker bids from foreign investors, said Jim Vogel, head of government
bond strategy at FTN Financial.

Foreign investors are
probably going to be slower to adjust to the expansion of U.S. borrowing
because “they have limited flexibility in terms of how many dollar investments
they can make,” Mr. Vogel said.

A separate set of Treasury
figures known as allotment data shows foreign demand fell below its five-year
average in March, after rising to a 21-month high in February. And the backdrop
for this year and the foreseeable future is more challenging.

The rise in government
borrowing is happening at the same time the Federal Reserve is reducing its
Treasury debt holdings. Some analysts think the Fed could continue to allow its
Treasury bond portfolio to shrink to half its $2.4 trillion size, reducing a
steady source of demand. It’s also occurring at the same time the Trump
administration is taking an increasingly confrontational approach to the U.S.
trade relationship with China, which is the largest foreign holder of
Treasurys.

A weak dollar is also making
it more difficult for some overseas investors to buy Treasurys by making it
more expensive to hedge currency risk. While this is less of a problem for
investors willing to bet on the greenback and for foreign central banks that
buy the debt to weaken their own currencies, some investors have opted to buy
European or Asian government debt instead.

Even as investors and
analysts remain concerned about the level of foreign demand proliferate, global
economic linkages and international trade create strong incentives for foreign
investors to continue to buy Treasurys. Major exporters such as China and
Japan, which are also the biggest foreign lenders to the U.S. government with a
combined $2.23 trillion of its debt, have their own motives to lend to the
largest customer for their exports and to keep their interest rates down, said
David Ader, chief macro strategist at Informa Financial Intelligence.

“It behooves them to
underwrite our debt because if we’re in a recession or worse, it would hurt
their economies as well,” Mr. Ader said.